The Reforms Era: A Redux

"Prediction is very difficult, especially about the future." Niels Bohr. 

On the contrary, we are generally smug about our ability of understanding the past. It is common wisdom that Dr Manmohan Singh and Mr P Chidambaram were the architects of India's economic reforms. Is it really true? As I watch the events unfolding before us, I am inclined to think otherwise. Ask a student who has studied Economics 101, he or she will know all about what is to be done if India is to progress in all spheres of development. The critical issue always hinges not on WHAT TO DO but on HOW TO DO!

     Ideas are dime a dozen; pay a rupee to any mediocre thinker and you would end up with ideas worth a hundred rupees. The game is all about implementation. Knowing what to do does not even put us on the starting block. Having known what to do, how much are we ready to stake in getting them done? In PV Narasimha Rao, we had someone who put his money where his mouth was. Politics is the art of achieving the possible and not what is ideal. With the type of contradictory political pulls that are typical of a noisy and dysfunctional democracy that is India, it requires limitless patience, political skills and perseverance to achieve what one sets out to do. Giving up is the easiest of options; talking what the chatterati want may win brownie points but all good intentions come to naught if the matching ability is not there.

     So, to whom do we credit whatever economic reforms that happened in 1991? Dr MMS appears too spineless going by what has happened since 2004. The powerless and supine nature of the good Sardar appears in stark relief to the political ability of PVN especially so when we compare their situations. In fact, the situation in 1991 was dire, the compulsions of coalition politics were more severe and PVN lacked a political base. He was a Prime Minister by default when he assumed office and he was also discredited in 1996. To add insult to injury, till date, the Congress treats him as almost an aberration. No Congress leader worth his or her name, dares to attribute any credit to PVR. All that we hear from the so called intellectual elite and the press is about how MMS and PC steered the country from a near disaster in 1991. 

     Probably the story cannot be more different that what we have been led to believe; Seeing the rudderless state of the Indian State, I am convinced more and more as days pass that the true credit of changing directions should be attributed to PVN completely. I am sure, with MMS or with any one with a reasonable understanding of economics, PVN would have still achieved the same result; perhaps, better. The politician in PVN just needed an intellectual figurehead for the sake of credibility and any one would with some reputation of intelligence would have equally fitted the bill. Misrepresentation of history has bequeathed a supine and pusillanimous MMS because of a mis-attribution of credit. It is noteworthy to remember another prime minister, Mr Atal Bihari Vajpayee who led a government under similar circumstances. In my opinion, history would be more charitable in future about the contributions of this remarkable individual who did more than what we think. The financial cushion for social expenditure of UPA - I can be completely attributed to responsible governance of ABV. Again, it was the right man at the helm who mattered, namely, ABV. 

     It is time the media and the chattering classes get out of their delusions about MMS and PC being the reformers. The true credit lies elsewhere and the earlier we understand it, the better off we would be.

The Short Changing of Shareholders

The Short changing of Share Holders:

Agency Cost:  Asymmetric Information and Moral hazard

Introduction

Markets, Firms and Regulators are supplementary (overlapping) as well as complementary structures that regulate exchange. The roles looked pretty neat in text but the reality – especially post 2008 looks much more complex and confusing.

The abyss which accosted the financial world in 2008 remains fresh in our minds. March 2008 saw the collapse of Bear Stearns and then the world seemingly returned to normal till the disaster of Lehmann Brothers. Alan Greenspan, who had looked prescient and omnipotent turned out to be the villain of the piece.  Knives were out for him but nothing apparently has changed. The fire caused by excessive credit and its securitization thereon is sought to be doused by more debt. Since then, the money presses of most central banks of the world opened up their spigots and as of now, the world is awash with cash. While the implications of this massive money creation are yet to be known and the stakeholders affected by the phenomenon are yet to reveal themselves, this small monologue will attempt to examine the consequences of the liberal nineties and the extravagant 2000s on the much maligned community of shareholders.

The Game Changers and Evolution of Modern Finance

The world of pre-modern Finance (by which I mean those times when leverage was an ugly word) was a simple, straightforward world where the parties involved were clearly identified as debtors and creditors. We knew the types of asset classes, the stake holders and the way money was supposed to oil the machines of world economies. Ever since the catch phrase of liberalization gained currency, the picture of modern finance with its attendant effects on the economies appears murkier. Distortions, as they seem now, are far larger and appear dangerous to the entire structure of global economy.

Though sounding trite, the cliché that dividends represent one of the most important structures of corporate governance is still worth remembering. Two models of financial engineering, in my view, have delinked the concept of dividends and corporate governance. The Black-Scholes-Merton formula and the Miller-Modigliani model have transformed the way global capital operates. Progress, it is said, is a vector quantity. The direction as well as the movement matter. While there has been significant movement in the theoretical underpinnings and applications of financial instruments in the wake of these two developments, jury is still out about the direction in which they have taken global finance.

Before delving into the implications of these two models, it is worthwhile recounting some salient assumptions that qualify the models.

Black-Scholes-Merton (1973)

The Black–Scholes model of the market for a particular stock makes the following explicit assumptions: 

• There is no arbitrage opportunity (i.e., there is no way to make a riskless profit).
• It is possible to borrow and lend cash at a known constant risk-free interest rate.
• It is possible to buy and sell any amount, even fractional, of stock (this includes short selling).
• The above transactions do not incur any fees or costs (i.e., frictionless market).
• The stock price follows a geometric Brownian motion with constant drift and volatility.
• The underlying security does not pay a dividend.

Miller-Modigliani

The basic theorem states that, under a certain market price process (the classical random walk) it does not matter what the firm’s dividend policy is and it does not matter how the firm is financed (raising capital or selling debt). The value of the firm remains unaffected by either way of financing but the model comes with the assumptions:-

• Absence of taxes
• Absence of bankruptcy costs
• Absence of agency costs
• Absence of asymmetric information
• Presence of an efficient market

Therefore, the Modigliani–Miller theorem is also often called the capital structure irrelevance principle.

The Ramifications

            With the development of communications for money transfer, relaxation of controls over capital mobility and a prolonged period of benign inflation which can be credited to the loose monetary policies of the US Fed coupled with the emergence of China as the manufacturing shop floor of the world, things looked never better in the 90s. Management education brought in fundamental changes in the way managers operated, family control over businesses yielded space to professional managers, cheap financing using junk bonds became fashionable and leveraged buy outs was the new game in town. Hedge funds entered the financial space in a major way and thereafter the linkages between share holders and the companies they purportedly owned started loosening up. Repeal of the Glass Steagall Act blurred the distinction between investment banking and the advent of the ‘quant trading’ coupled with high power processing speed opened the flood gates of flash trading, trading on proprietary account, taking up contra positions on own trade, limited disclosure to clients and the ability to cash on momentary arbitrages across global markets. Integration of trading structures and high speed connectivity helped the process. Over the counter trading of futures, options, derivatives, securitized debts and credit protection enticed the uninformed as well as the well informed into the trading. The almost limitless availability of cheap debt breathed a new life into the debt and securities markets. Financial services, which traditionally used to contribute about 2.5 percent to 3 percent of GDP as a long term average peaked in 2008 to about 7.5 percent of the GDP and reporting more than 40% of corporate profits of the USA. At the peak of the crisis, Bear Sterns was leveraged up to almost 40 times its capital and Lehman Brothers had reached a leverage ratio of 50 times.

            Rating agencies contributed to the mess further by entering the field of rating securitized debt which included credit card loans, housing loans and other consumer loans. The nature of the products essentially slipped under the horizon of a not too watchful regulatory authority. Special Purpose Vehicles were used by the Wall Street to move excess leverage off their balance sheets to bypass capital adequacy requirements, rating agencies cooperated by giving ratings to such securities for which default prediction models did not exist. Players like AIG took upon the task of credit insurance of such scale and of such dubious quality that it increased the risk of counter party insurance and magnified the risks to the entire economy which were specifically rooted in the financial sector.

            The finance and finance products community essentially spiked their own profits with excess leverage and rewarded themselves with bonuses. The unfortunate side effect of securitization of mortgages manifested itself as cheap credit which fuelled consumption and led to unsustainable leverages in the household sector. There are strong reasons for me to point out these issues because the centrality of shareholders who financed investment through their own savings became irrelevant to the entire economy. In this haze, there was market failure, regulatory failure, principal-agent problems and a massive information asymmetry all of which came at the cost of share holders and the tax payers. Sectoral composition of debt among various countries is given above for a better understanding. The gross debt of nations in relation to their GDPs tell their own story. A caveat needs to be added in the sense that the destination of the debt would also be of equal interest. Debt which adds to consumption in countries that over consume or the debt which adds to capacity in countries which suffer already from over capacity is essentially a drag on the economy. Though the ideal mix of consumption;investment would be a matter of conjecture and speculation, it is possible for the armies of economists employed by the Central Banks to figure out some band which would be typical for each country.

Problem of Seignorage

            Post Brettonwoods, the financial architecture of the global economy was firmly anchored on the US dollar. Other currencies that were freely tradeable formed a minority portion of foreign currency reserves of nations. The Asian crisis, Russian and Argentinian defaults focused the attention of developing nations towards accumulation of sizeable foreign currency reserves. Thus, a free channel for monetizing the debts of developed nations became available. US and Europe emerged as major consumers of developing world merchandise and the trade surpluses found their way back to either sovereign or other forms of debt of the developed world. There was a need to keep a cheap currency regime for exports of developing countries which resulted in an indirect subsidy for the developed world and wage/demand suppression of the developing world. The resources which were and are being transferred in this fashion can be viewed as the seignorage tax. In a free regime of capital transfer and property titles, the developing world could have acquired real assets in the developed world using trade surpluses. However, that case was not to be as discriminatory barriers were erected by policy makers of the developed world so that trade surpluses got channelized almost exclusively into debt thus fuelling consumption in the developed world, indirectly contributing to increased exports.

            This seignorage has given the ability to the Central Banks of the developed world to go in for massive balance sheet expansions. These expansions were initially directed at saving the banking system from both liquidity and solvency crises in the developed world. Progressively, the expansions have now assumed the role of funding sovereign debt both in Eurozone as well as the USA for the purpose of funding unemployment payments, food stamps and health care. Absent seignorage, such injections of base money supply into local economies would have resulted in hyper inflation as well as a massive devaluation of local currency and increase in nominal interest rates. However, the developing world which had built a large corpus of foreign reserves is now hoist at its own petard. It can neither stop buying debt nor allow a fall in the value of debt instruments which will happen if interest rates rise in the developed economies. Thus, the developed world continues to consume excess global resources at zero cost and a massive wealth transfer is happening where the poor of the developing world subsidise the not so poor of the developed world. Developing world cannot afford to raise wages (which will enable increased consumption in domestic markets to offset the loss of demand from developed world) for the fear of losing jobs. Whereas the current reserve accumulation can also not continue forever as poor cannot keep subsidizing the rich for prolonged periods. Something has to give. What will give and when it will happen is a matter of conjecture but it can be reasonably assumed that the global economy, as in the present state, exists in a state of an unstable equilibrium. A comparative table which
 indicates the monetary (base money supply) expansion of the developed world can be seen above for better understanding.

The Failures and the Causes

            All the discussion above has led the essay, a bit away from the central theme of share-holder compromise. However, it is necessary to understand the macro perspective fully before we can continue further on the topic. What we have so far seen above is a failure of the market, failure of regulators and collusion between regulators, governments and the financial sector in a scale that discredits both the models that were listed at the beginning of this essay. In brief, I would summarise the situation as I see it in the following manner:-

·         Moral Hazard In economic theory, moral hazard is a tendency to take undue risks because the costs are not borne by the party taking the risk. The term defines a situation where the behavior of one party may change to the detriment of another after a transaction has taken place. In the global economy, moral hazard has now become an entrenched phenomenon where developed world indulges in monetary expansion at the cost of the developing world, creditors are squeezed in Eurozone to accept voluntary haircuts in the value of their debt, creditors being forced to lend at ridiculously low rates to States that already have an unsustainable debt and the managerial compensation of the financial services sector bears no relation to the economic hazard it poses to the health of nations

·         Subsidization of sovereign debt Interest rate regime in the developed world has remained at abnormally low levels since 2008 and, as per the declarations of both US Fed as well as the ECB, are likely to remain so till at least 2014. This has implications for both global and local economic situation. Globally, the developing world which exports resources and finished goods to the west, would be forced to absorb excess foreign currency influx to maintain exchange rates and sanitise the excess local currency released into their own economies. Inflation in the developing world is a certainty, given the circumstances. In addition, domestic demand would remain suppressed and investment into excess capacity cannot be avoided as the surpluses of trade do not reach the hands of the working class who are the consumers.

·         Collapse of Capitalist welfare state model The capitalist welfare model as obtaining in the developed world is almost at a state of collapse and the absolute collapse awaits the triggers of high energy prices, loss of seignorage and drop in confidence of the western currencies. However, any corrective action in this regard is still not in sight as the majority opinion of the political class in this part of the world is still not capable of taking the hard decisions that would rectify the imbalance. Evolution of a common exchange mechanism that would not be influenced by the Central Banks still remains a mirage. But, the equilibrium remains unstable.

The future of shareholder

            The future of the shareholder remains foggy. Mutual funds as an option for investment in capital markets seems jeopardized due to asymmetric information between the funds and the investors and the agency costs. Trading on own account for share holders is a strict no-no as the shareholder is in no position gauge the macroeconomic fundamentals for long term investments nor is he or she in a position to take advantage of short term swings in prices. In both cases the shareholder is defeated by the technology barrier. Companies indulging in stock repurchases to return value to shareholders complicate the issue further. The results of repurchases are often manifested as reduction of shareholder oversight, increase of leverage, reduction in shareholder value if price is above the true value of company, stock reissues which dilute shareholder value at a later stage and the stock options offered to senior management who then have a vested interest in manipulation of the stock price.

Conclusion

The central question which comes to my mind is this; Who owns the company? There are no easy answers to this question as experience suggests that genies which leave the bottle find it hard to return to them on their own. Notwithstanding the cynicism, I feel that it is time for us to a financial system in which companies are built for the long term, and investors' ideal retirement portfolio consists of shares in substantial companies, paying dividends. The current system, in which the retired are supposed to invest in bonds with pathetically low interest rates, or speculate short-term in the stock market, buying and selling like day-traders in the hope of capturing capital gains, is far too demanding of individual investors and turns the market into a casino. Shareholder capitalism has been proven over a century in the west to be the best known wealth creation mechanism for individuals. Managerial capitalism has failed due to the reasons discussed above and hence it is time we travelled back in time.